As the dust settles on the market panic triggered by Kwasi Kwarteng’s botched mini-Budget, the contours of another economic crisis are already becoming visible. After an unusually hot and arid summer, millions of working people in Britain are now bracing for what may turn out to be a particularly cruel winter. In August the Bank of England forecast five quarters of recession, inflation soaring to over 13 per cent and the worst collapse in living standards since records began. As fuel prices continue to rise, these developments are expected to drive more than half of all families in the UK into energy poverty by the start of 2023.
What are the main drivers behind this historic cost-of-living crisis? And what can be done to resolve it, or at least to mitigate its worst effects? In truth, there is no one factor that is driving up prices – and for that reason there will be no quick fix to the problem either. Instead, the global economy faces a perfect storm: a confluence of interlocking crises, each of which is unleashing a unique set of inflationary pressures in different parts of the world.
In fighting this latest surge of inflation, the Bank of England claims to have only two blunt policy instruments at its disposal: it can depress aggregate demand by raising central bank interest rates, and it can reduce the amount of money in circulation by selling the financial assets on its own balance sheet (a policy known as quantitative tightening, or QT). This type of monetary contraction may be a bitter pill to swallow, we are told, but it is a necessary medicine for an ailing patient. Without aggressive central bank action, inflation will simply run out of control.
Unfortunately, this story is dangerously misleading. Pursuing these deflationary policies at such a critical juncture in the post-pandemic recovery will only aggravate the cost-of-living crisis by pushing up unemployment, lowering wages and deepening the recession, while doing nothing to cut the prices of essential goods. In fact, relying on higher interest rates will only achieve one thing: it will shift the burden of adjustment for this crisis onto the most vulnerable members of society – those who are least responsible for causing it to begin with. To understand why, several myths about the drivers of inflation need to be dispelled, as well as the mistaken faith in the capacity of central banks to fix them.
For conservatives, there remains a widespread belief that inflation is always and inevitably a result of excessive money creation. Pointing to the historically low interest rates of the past decade, as well as the expansion of the money supply through the unconventional policy of quantitative easing (QE), many on the right continue to argue that today’s rising prices were caused by a lack of monetary discipline. Liz Truss, the Prime Minister, has echoed this view, declaring that “we have not been tough enough on the monetary supply”.
The problem with such claims is that they are based on an outdated economic theory, known as monetarism, whose basic premises have long since been discredited. The leading proponent of this view, which gained prominence during the early 1980s, the Chicago School economist Milton Friedman, famously argued that “inflation is always and everywhere a monetary phenomenon in the sense that it is and can be produced only by a more rapid increase in the quantity of money than in output”. Monetarists therefore propose to respond to all forms of inflation in the same way: by restricting the amount of money in circulation.
Today, Friedman’s acolytes can still be found sporting bow ties and matching handkerchiefs in fancy American business schools, or launching diatribes against the US Federal Reserve in the pages of the Wall Street Journal. Beyond these usual suspects, however, monetarist views have largely fallen out of favour among professional economists, subsiding into a fringe phenomenon maintained by a few right-wing think tanks and shadowy Bitcoin forums. The reason for this is that monetarism has fared rather poorly in light of real-world developments.
Most significantly, it failed to adequately predict the outcome of the greatest monetary experiment in modern history. In the years after the 2008 financial crisis, central banks desperately tried to boost aggregate demand by pumping trillions of dollars’ worth of new money into the world economy through their QE programmes. Even then, consumer prices consistently refused to budge. This confused central bankers and contradicted the doomsday prophecies of the monetarist creed. If Friedman was right, and money creation inevitably leads to rising prices, the world should have been hit with hyperinflation many years ago. Yet central bankers actually faced the opposite problem, struggling to push up prices enough to even reach their 2 per cent inflation target, despite flooding the markets with money.
Ultimately, the reason that QE did not unleash an inflationary spiral was that most of the new money remained trapped within the financial system. Quantitative easing rested on a faulty assumption that the liquidity created through central bank asset purchases would eventually “trickle down” to businesses and households, which would then push up consumer prices by spending it in the real economy. Instead, investors used the newly created money to speculate on equities and real estate, fattening the pockets of the rentier class. The result was a different kind of inflation: asset price inflation, blowing up huge speculative bubbles in the stock market and housing market.
If even trillions of dollars in new money creation failed to push up consumer prices in the pre-pandemic years, how are we to account for the inflationary pressures this time around? In the US, Republican politicians have predictably fixated their ire on the “profligacy” of their Democratic counterparts, blaming rising prices on Joe Biden’s fiscal response to the pandemic: the $1.9 trillion American Rescue Plan. Inflation, the Republican Senate minority leader Mitch McConnell complained in 2021, is “a direct result of flooding the country with money. The last thing we need to do is pile on with another massive, reckless tax and spending spree.”
This familiar refrain may play well in mid-term elections in November, but it is also easily belied by the evidence: inflation was already at its highest level in a decade before Biden had entered office. Nevertheless, accusations of excessive government spending have recently received a degree of mainstream respectability with the interventions of two influential establishment economists: Larry Summers, the former US Treasury Secretary, and Olivier Blanchard, the former chief economist of the International Monetary Fund. Having warned for months that Biden’s spending plans would fuel higher inflation, both men now feel vindicated. “We put too much demand into the economy last year,” Summers has said, “and inevitably that was gonna cause it to overheat, which it has.”
But this view, too, is not supported by the evidence. In August the Economic Policy Institute compared the US pandemic response to a set of smaller government interventions in other wealthy economies. It found that “despite the different fiscal responses, essentially all of these countries have experienced a rapid acceleration of core inflation”. On its own, government spending therefore cannot be the determining factor behind the cost-of-living crisis. The main causes must lie elsewhere.
The real drivers of inflation have been staring us in the face all along. To find the origins of our troubles, we need look no further than the two largest supply shocks to hit the world economy since the Second World War: the Covid-19 pandemic and the war in Ukraine.
The first wave of inflation began in 2021 and was largely a result of the collision between snarled-up supply chains and sudden shifts in demand in response to the pandemic. As billions of people went into lockdown and then emerged from it with savings to spend, their patterns of consumption rapidly changed, leaving producers and retailers unable to adapt fast enough. Suddenly, labour scarcities and physical blockages in the supply chain led to shortages of a wide range of goods, from bicycles to microchips. Containers piled up in ports, oil tankers lay in wait offshore, aeroplanes remained stuck on the ground and long-haul truckers languished in quarantine. The resultant mismatches between supply and demand raised the prices of many goods.
These initial inflationary pressures were widely expected to be transitory, but just as some of them were beginning to ease early this year the world was rocked by another historic supply shock when Russia invaded Ukraine. As the West responded with a barrage of economic sanctions, it effectively severed Russia – one of the leading producers of oil, gas, wheat and fertiliser – from half of the world economy. Widespread concerns over food and fuel shortages gripped global commodity markets. As the economist Jayati Ghosh has noted, financial speculation then drove up prices far in excess of any real-world shortages.
Combined with a renewed round of lockdowns in China, the economic fallout of Russia’s invasion ensured that the transitory price rises of 2021 persisted deep into 2022. In an analysis of last May’s consumer price data, Mark Zandi of Moody’s Analytics found that the war in Ukraine was by far the leading cause of inflation, even in the US, where it was responsible for over 40 per cent of total price increases (the number is likely to be much higher in Europe).
On top of all this, climate change then became an aggravating factor in the supply chain chaos as well. This summer’s unusually hot weather led to some of the worst droughts on record, stunting crop growth and drying out river beds throughout the northern hemisphere. Low water levels directly impacted energy prices across Europe by reducing coal transport in Germany, nuclear power generation in France and hydropower capacity in Norway. With the recent sabotage of the undersea Nord Stream gas pipelines and the announcement of a new oil output cut by the Organisation of the Petroleum Exporting Countries, this perfect storm is likely to keep energy prices high for the near future.
Unfortunately, central banks lack the power to change any of this: raising interest rates will not magically end the war in Ukraine, cause China to abandon its zero-Covid policy or bring an end to climate change. What it will do is smother the post-pandemic recovery, push up unemployment, lower wages, raise interest payments on mortgages and reduce the capacity of small firms to borrow. With investors on edge it could even trigger a global wave of financial crises: from a debt crisis in the developing world to a stock or housing market crash in the developed world. As in the previous financial crisis of 2008, working families – those who are already bearing the brunt of the rising cost of living – will stand to lose the most.
Given the enormous social costs of an aggressive monetary contraction – and the lack of any clear economic benefits to society – the critical question is: why are central bankers doing this? The answer from on high is that inflation is now threatening to become entrenched. Andrew Bailey, the governor of the Bank of England, has even warned that the UK is at risk of a wage-price spiral similar to the 1970s, urging workers to show restraint and not to demand any pay increases in response to the rising cost of living. The idea here is that higher wages would depress profits, which would then propel companies to further raise prices, feeding into a vicious cycle that will cause inflation to spiral out of control.
This argument is impossible to reconcile with the facts. As the Bank’s officials know, real wages in the UK actually fell at a record rate of 3 per cent last quarter, according to the Office for National Statistics. Despite a recent rise in strike activity, the weakened bargaining position of organised labour compared with the 1970s makes it unlikely that workers will obtain pay rises commensurate with inflation. Even in the US, where job growth remains strong, real wages adjusted for inflation continue to fall. Objectively, there is no threat of a wage-price spiral. Why, then, is Bailey pushing this false narrative? The benevolent interpretation is that he is guided by misplaced fears from a bygone era. A more likely explanation is that the head of Britain’s financial establishment is playing his expected role in shoring up an economic system that benefits the financial establishment.
For all their claims to independence and expertise, central bankers remain political actors. It is necessary to demystify the positions of power that these unaccountable technocrats hold in our financialised societies. Monetary policy has never been politically neutral, and raising interest rates in the present circumstances will have far-reaching redistributive implications. It will benefit creditors at the expense of debtors, wealthy savers at the expense of poorer households, and the owners of capital at the expense of small businesses. With this in mind, it is impossible to forego the conclusion that central bankers are consciously offloading the costs of the crisis onto the most vulnerable members of society.
Working people now find themselves at the receiving end of a vicious class war. Nowhere is the outcome more clearly on display than in the discrepancy between falling real wages and the record profits of the large energy, food and retail companies. Even as millions of families are thrown into poverty, unable to heat their homes or put enough food on the table, corporate profits are soaring to new highs. According to a recent analysis by the Economic Policy Institute, private companies have captured 54 per cent of pandemic-era price increases in the form of higher profits, with less than 8 per cent going to wages.
This is where the real threat of an inflationary spiral now comes from: not from workers demanding higher wages to compensate for their loss of purchasing power, but from powerful businesses engaging in price gouging at the expense of the general public.
What can be done to overcome this dismal state of affairs? Clearly, an aggressive monetary contraction only threatens to make matters worse, engineering an economic collapse that will condemn millions of families to hunger and energy poverty. What is needed above all is a comprehensive political solution: a targeted set of government interventions to reduce the price of essential goods while continuing to secure high employment and fair wages. Above all, breaking the back of inflation will require resolving supply-side issues and ensuring an equitable transition to a green economy with affordable clean energy, food and housing.
In the short-term, there is no fast remedy to resolve this multidimensional crisis. Rather, as the economists Isabella Weber and Mark Paul have argued, what is needed is a “surgical approach that reins in the price increases that have been driving inflation, while encouraging investments to overcome chronic supply chain issues”. This will require some mix of price controls, income support and windfall taxes on the fossil fuel giants and other large companies. For the UK, where energy poverty is a particularly acute concern, it would also make sense for the government to take the energy sector back into public ownership and secure supply to the most vulnerable households while establishing the infrastructure for a renewable energy economy.
Such targeted state interventions will undoubtedly prove anathema to the disciples of Milton Friedman, whose outdated ideas continue to weigh like a nightmare on the brains of the living. But in the absence of meaningful government action, rising prices will eventually tip millions of people over the edge. As the public mood worsens, the prospect of civil disobedience and social unrest will grow more likely. Already, more than 193,000 people have signed up to Don’t Pay UK’s campaign, pledging to halt the direct debit payments on their unaffordable gas and electricity bills. As the energy crisis really starts to bite later in the year, this may yet prove to become this generation’s winter of discontent.